Why Nintendo is in no hurry for Wii2

Nintendo has three functions in the video game business of which most journalists and analysts seem to focus on just one. Today I'd like to look at the health of the Wii platform in reference to those three areas.

Hardware manufacture

Most Nintendo observers focus on it's hardware business. While Nintendo hardware has blown away the competition in recent years, so far this year the Wii platform seems to be falling behind.

Worldwide Hardware 2011 (YTD)
Console Yearly    Total
------- ------    -----
PS3     1,817,179  48,163,035
DS      1,743,582 145,707,365
X360    1,677,025  52,065,666
Wii     1,676,899  85,336,683
PSP     1,046,947  66,433,522
PS2       474,050 142,132,409
3DS       374,164     374,164
Total   8,809,846  

(All charts taken from VGChartz.)

Considering that the DS, in its various forms, has been the best selling game machine since 2006, Nintendo did well to shift to the 3DS, which seems to be off to a fast start. Meanwhile, the Wii maintains a large lead in total consoles sold among current systems, but is clearly losing momentum at an alarming rate. Since this is the number most people focus on, Nintendo seems to be in trouble. By 2010 the handwriting was on the wall for both of Nintendo's platforms:

Worldwide Hardware 2010
Console Yearly     (change) Total
------- ------     -------- -----
DS      21,445,632 (-25%)  143,963,783
Wii     18,345,329 (-15%)   83,659,784
PS3     14,443,529 (+11%)   46,345,856
X360    13,606,638 (+34%)   50,388,641
PSP      9,298,210 (-11%)   65,386,575
PS2      4,591,780 (-24%)  141,942,000
Total   81,731,118 (-9%)  

It's important to know that historically Sony and Microsoft lose money on each console sold and Nintendo makes a moderate profit. This late in the console cycle, it's likely that all three consoles are making money, but Nintendo has always profited from Wii sales. In addition, the Wii's already large install base makes selling new consoles harder.

Software publishing

Nintendo's second role in the industry is as game publisher. In this case, Nintendo's DS and Wii game sales far exceed all competitors with the possible exception of EA.

Worldwide Publisher Totals 2011 (YTD)
Pos     Publisher                    Yearly
---     ---------                    ------
1       Nintendo                    10,901,624
2       Electronic Arts              9,019,470
3       Activision                   6,813,847
4       Ubisoft                      6,694,007
5       Sony Computer Entertainment  4,922,930
6       Microsoft                    3,724,148
7       THQ                          3,303,488
8       Sega                         2,674,190
9       Capcom                       2,568,090
10      Namco Bandai                 2,540,164

While Nintendo has a big lead over EA in terms of unit sales, that seems to include games packed with hardware and does not include downloadable content. So while it's conceivable that EA and Activision have been more successful, by no means is Nintendo failing as a publisher.

Most publishers rely on a hit game system which results in huge sales in the months following a game's launch after which they move to the next title. Nintendo, which has been the leading publisher for years, has been able to create and market "evergreen" titles that sell well for several years. Along with Microsoft and Sony, Nintendo has the advantage that each software release increases the value of their hardware business. Nintendo re-releases titles from their back catalog more successfully than any other competitor. Each of these strategies minimize development costs and increase profits both for DS and Wii games.

Platform licencing

Finally, Nintendo takes a cut of every title sold for one of its platforms. When it comes to evaluating launching a new platform, total software sales has to be a primary consideration. A new console is a huge expense and risk for the manufacturer, consumer and game publishers. The only people who benefit with certainty from a console launch are the journalists who cover the story. As long as games are still selling on a hardware system, there's just no reason to replace it.

Worldwide Software Totals 2011 (YTD)
Console Yearly     Total       (tie ratio)
------- ------     -----       -----------
Wii     22,696,263 637,024,525 (7.46)
PS3     18,246,636 349,149,161 (7.25)
X360    18,227,812 476,688,453 (9.16)
DS      13,323,937 650,342,875 (4.46)
PSP      6,130,249 195,271,066 (2.94)
PS2      1,773,060     n/a
PC       1,349,242     n/a
3DS        344,446     n/a
Total 82,091,645

By game sales, the Wii is still the most successful console due in part to its massive install base. Notice that a console, such as the PS2, can enjoy a very long software life after production ends. A critical statistic for a console is the tie ratio, which compares the total games per console sold. The average Xbox owner has a library of 9 or so games while average Wii and PS libraries hold just over 7 titles. Since people continue to buy software after they buy the console, the number will tend to increase over the life of a system, which is why the oldest system has the highest number. Handheld tie ratios will naturally be lower if only because some households will buy multiple systems and share a software library. Tie ratios matter to the consumer because the more games they own and enjoy, the better value they wring from the console. They matter just as much to a hardware manufacturer because they represent incremental profit on top of the original hardware sale.

Worldwide Software Totals 2010
Console Yearly      (change) Total       (tie ratio)
------- ------      -------- -----       -----------
Wii     182,616,765 (+2%)    614,328,262 (7.34)
X360    141,041,533 (+24%)   458,460,641 (9.10)
PS3     126,996,359 (+38%)   330,902,525 (7.14)
DS      119,157,411 (-17%)   637,018,938 (4.42)
PSP      40,577,954 (+9%)    189,140,817 (2.89)
PS2      15,938,237 (-42%)       n/a
PC       10,153,009 (-)          n/a
Total   636,481,268 (+7%) 

This chart shows the 2010 sales by platform and reveals that Wii software actually increased year-over-year, though not nearly as much as its rivals. The DS, meanwhile, entered the decline portion of its life-cycle, which pushed the introduction of the 3DS. Since the company will not be able to support two simultaneous console launches, a Wii sequel wasn't in the cards for 2011. But if Wii sales slow this year, Nintendo may need to announce its next console soon.

Why I bought yet more First Marblehead

After the most recent First Marblehead release, the market gave me an offer I couldn't refuse. According to my calculations, the current liquidation or run-off value of the company is $9.80 a share. That number assumes shares will be diluted 20% according to the Goldman Sachs deal. Then I calculated a conservative guess of the company's value assuming it is able to return to some sort of stable business. I'm guessing the company is worth $38 or more if they are able to convert some of their loans on the balance sheet into earnings. Note that I'm not assuming they will get the same sort of securitization deals they received a year ago—just that they find buyers or financing to turn their loans into earnings at some point.

Personally, I think this whole crisis will blow over in a year or two and Marblehead and Sallie Mae will survive as a bunch of competitors will disappear. As survivors, their earnings power will dramatically increase and $38 will seem laughably cheap. But for the sake of argument, let's use that number. I also expect survival has a better than 90% chance, since Goldman Sachs has a stake in the company. But to prove the point, I'll assume the survival odds are 50%. My expected price, therefor, is $24 and my Kelly ratio is 39%. So I bought more shares at $14.95 to boost my First Marblehead position and reduce it's cost basis.

In my opinion, First Marblehead will be able to continue as a going concern whether or not it is able to securitize loans. Those loans will provide consistent, high-return cash flow to someone over the next few decades, so someone will buy them or finance Marblehead to keep them. It's not dissimilar from Microsoft shifting from selling shrink-wrap software to collecting service reviews. Either way they are selling something valuable and it's just a matter of how to collect profits. So this purchase is not a bet on the securitization market, but a bet on First Marblehead's business.

Could monopolies be healthly for the software industry?

Reading commentary about Oracle's BEA offer made me wonder if monopolies really are bad for software consumers. Logically, monopolies are detrimental in every industry because a single supplier is able to control prices that customers must pay. But there are some cases where a monopolistic structure seems to be not so bad or at least a natural result in certain industries.

In software, there are only two real factors in a purchasing decision: price and features. Price isn't just the amount that goes into the software company's pocket, but also the cost to implement and maintain a system. For large systems, the cost to simply train users might dwarf all other costs combined. As Microsoft has taught us, the biggest company tends to win out when price is the primary factor if only because training costs can be minimized. Nobody bothers to mention "Microsoft Windows" or "Microsoft Office" on a resume anymore, because every halfway qualified candidate has learned to use those programs already.

The other factor is features. Since the biggest companies have a huge advantage on the price side of the equation, upstart companies must compete on features. In my experience, it's fairly difficult to justify spending more on software on the basis of "nice-to-have" features. So in order to compete with bigger competitors, a small software company needs to create functionality that is so totally different and useful that its customers start to depend on it. For instance, a few years ago I purchased a copy of Quicken that downloads all of my transactions from my bank's website. Since I've grown to depend on this feature, Intuit has locked me into their software indefinitely.

The other lesson Microsoft has taught us is that big companies have an advantage when it comes to features as well, if the big companies catch the trend soon enough to copy the feature. For instance, Excel, Word, Windows, Money, Internet Explorer, and Outlook were introduced in order to outflank Lotus 123, WordPerfect, Macintosh, Quicken, and Netscape. There are dozens of smaller examples as well. Apple and Intuit survived only because they stayed under the radar long enough to lock-in a critical mass of customers before Microsoft moved in. Other competitors, such as Google, have thrived because Microsoft didn't understand their features until it was too late to emulate. Notice that these mistakes and oversights have occurred more often as Microsoft and the software industry have grown. It's just too hard for them to see everything that is going on.

From the customer's viewpoint, the Microsoft monopoly has been surprisingly benign. Sure, personal computers are probably too expensive because of the Windows and Office taxes, but cooperate America's software training costs are probably lower than they would be with more variety. It's hard to say if we are suffering from a lack of features, but until recently Microsoft has been the leader in distributing new types of software. Where they have failed, it seems like some other company has filled in the gap fairly quickly. In either case, innovation has thrived under the Microsoft monopoly to a greater extent than is possible to imagine under the IBM monopoly of the the 1970's.

Of course, once a monopoly develops, there is a new reason to buy software from a particular company: there is no other choice. And if everyone knows the monopolistic company will simply copy any new and revolutionary product, there is little reason for startups to startup. On the other hand, if the biggest companies are willing to buy up smaller players, like Microsoft in the 1990's and Oracle in the last three years, there is an incentive to fill functional gaps. From the market leader's perspective, purchasing successful competitors when they are small is both cheaper and more certain than developing their own copy. Customers also benefit, since the original products tend to be better than the imitations, at least for a while.

So the dynamics of the software industry may produce benevolent monopolies if:

1. Big companies drive down the total cost of software ownership.
2. Small companies have an incentive to compete on features and are not overly afraid of their ideas being copied by larger companies.

It's like a pond with two niches: small fish (that specialize in features) and big fish (that reduce overall price). Companies like BEA are in the uncomfortable middle: too big to be truly innovative and too small to be cost effective for customers. In this case, if the big fish swallows the medium-sized one, it might be best for the entire ecosystem.

Ellison's NetSuite investment

Larry Ellison is very close to pushing his NetSuite venture onto the public markets and it's got folks worried about a potential conflict of interest. Before everyone gets carried-away-er, I'd like to point out that Ellison's fortune is almost fully tied to Oracle, so there is every reason to assume that he will put Oracle shareholders ahead of NetSuite shareholders. To illustrate, at the moment, Mr. Ellison's Oracle holdings are worth $24.5 billion. Assuming the NetSuite IPO sells at the high end of its range, his holdings in that company would be about $555 million. If NetSuite catches up to Salesforce.com in terms of market capitalization, Ellison's investment would be worth about $3.7 billion. In other words, NetSuite's current contribution to his net worth is a rounding error with the potential to become pocket change.

Ironically, the horses left the barn two years when Oracle bought Siebel and stepped more firmly in the on-demand side of business software. Before that, Ellison had reduced his role in NetSuite's operations and ended a licensing deal that allowed NetSuite to use the Oracle name to promote its service. NetSuite's IPO gives reporters an excuse to write about the situation, but in reality it's just another step on the path of disengaging from the smaller company. Once there is a public market for his shares, he'll be able to sell part of his stake.

At the moment, Oracle and NetSuite don't directly compete for business, which means they currently have a symbiotic relationship—Oracle sells database and middleware software to NetSuite and NetSuite fills a niche that Oracle has left vacant. But that relationship can't continue much longer. Hosted business software for small business is the next frontier for any number of software companies including Oracle, Microsoft, Google, and SAP. In addition, there are established companies like NetSuite, Salesforce.com, RightNow, and Intiut. So Ellison's two companies are on a collision course and he's jumping off the little ship to ride the bigger one.

As an Oracle investor, there isn't much to worry about here. Larry Ellison has far too much invested in Oracle financially, professionally, and personally. NetSuite offers him and his children an opportunity for a higher return than is currently available with Oracle, but there isn't much chance it will every rival Oracle in absolute terms. Future NetSuite investors must be aware of the issue, but that's just a part of due diligence.